CONCEPT OF RETURN AND RISK

There are different motives for investment. The most prominent among all is to earn a return on investment. However, selecting investments on the basis of return in not enough. The fact is that most investors invest their funds in more than one security suggest that there are other factors, besides return, and they must be considered. The investors not only like return but also dislike risk. So, what is required is:i . C l e a r u n d e r s t a n d i n g o f what risk and return are,i i . W h a t creates them, andiii.How can they be measured? Return: The return is the basic motivating force and the principal reward in the investment process. The return may be defined in terms of (i) realized return, i.e., the return which has beenearned, and (ii) expected return, i.e., the return which the investor anticipates to earn over some future investment period. The expected return is a predicted or estimated return and may or maynot occur. The realized returns in the past allow an investor to estimate cash inflows in terms of dividends, interest, bonus, capital gains, etc, available to the holder of the investment. The returncan be measured as the total gain or loss to the holder over a given period of time and may bedefined as a percentage return on the initial amount invested. With reference to investment in equity shares, return is consisting of the dividends and the capital gain or loss at the time of saleof these shares. Risk: Risk in investment analysis means that future returns from an investment areunpredictable. The concept of risk may be defined as the possibility that the actual return maynot be same as expected. In other words, risk refers to the chance that the actual outcome (return)from an investment will differ from an expected outcome. With reference to a firm, risk may bedefined as the possibility that the actual outcome of a financial decision may not be same asestimated. The risk may be considered as a chance of variation in return. Investments havingg r e a t e r c h a n c e s o f v a r i a t i o n s a r e c o n s i d e r e d m o r e r i s k y t h a n t h o s e w i t h l e s s e r c h a n c e s o f variations. Between equity shares and corporate bonds, the former is riskier than latter. If thecorporate bonds are held till maturity, then the annual interest inflows and maturity repayment are fixed. However, in case of equity investment, neither the dividend inflow nor the terminal price is fixed.Risk should be differentiated with uncertainty: Risk is defined as a situation where the possibilityof happening or non happening of an event can be quantified and measured: while uncertainty isdefined as a situation where this possibility cannot be measured. Thus, risk is a situation when probabilities can be assigned to an event on the basis of facts and figures available regarding thedecision. Uncertainty, on the other hand, is a situation where either the facts and figures are notavailable, or the probabilities cannot be assigned. Types of Risk:Systematic Risk:

It refers to that portion of variability in return which is caused by the factorsaffecting all the firms. It refers to fluctuation in return due to general factors in the market suchas money supply, inflation, economic recessions, interest rate policy of the government, politicalfactors, credit policy, tax reforms, etc. these are the factors which affect almost all firms. Theeffect of these factors is to cause the prices of all securities to move together. This part of risk arises because every security has a built in tendency to move in line with fluctuations in themarket. No investor can avoid or eliminate this risk, whatever precautions or diversification may be resorted to. The systematic risk is also called the nondiversifiable risk or general risk. Types of Systematic Risk: 1. Market Risk: Market prices of investments, particularly equity shares may fluctuate w i d e l y within a short span of time even though the earnings of the company are n o t changing. The reasons for this change in prices may be varied. Due to one factor or the other, investors attitude may change towards equities resulting in the change in market price. Change in market price causes the return from investment to very. This is known asmarket risk. The market risk refers to variability in return due to change in market priceof investment. Market risk appears because of reaction of investors to different events.There are different social, economic, political and firm specific events which affect them a r k e t p r i c e o f e q u i t y s h a r e s . M a r k e t p s yc h o l o g y i s a n o t h e r f a c t o r a f f e c t i n g m a r k e t prices. In bull phases, market prices of all shares tend to increase while in bear phases, the prices tend to decline. In such situations, the market prices are pushed beyond far outof line with the fundamental value. 2. Interest-rate Risk: Interest rates on risk free securities and general interest rate level are related to each other. If the risk free rate of interest rises or falls, the rate of interest on the other bond securities also rises or falls. The interest rate risk refers t o the variability in r e t u r n c a u s e d b y t h e c h a n g e i n l e v e l o f i n t e r e s t r a t e s . S u c h i n t e r e s t r a t e r i s k u s u a l l y appears through the change in market price of fixed income securities, i.e., bonds anddebentures. Security (bond and debentures) prices have an inve rse relationship with thelevel of interest rates. When the interest rate rises, the prices of existing securities fall andvice-versa. 3. Purchasing power or Inflation Risk: T h e i n f l a t i o n r i s k r e f e r s t o t h e u n c e r t a i n t y o f purchasing power of cash flows to be received out of investment. It shows the impact of inflation or deflation on the investment. The inflation risk is related to interest rate risk because as inflation increases, the interest rates also tend to increase. The reason being that the investor wants an additional premium for inflation risk (resulting from decreasein purchasing power). Thus, there is an increase in interest rate. Investment involves a postponement in present consumption. If an investor makes an investment, he forgoes theopportunity to buy some goods or services during the investment period. If, during this period, the prices

of goods and services go up, the investor losses in terms of purchasing power. The inflation risk arises because of uncertainty of purchasing power of the amountto be received from investment in future. Unsystematic Risk: The unsystematic risk represents the fluctuation in return from a n investment due to factors which are specific to the particular firm and not the market as a whole.These factors are largely independent of the factors affecting market in general. Since thesefactors are unique to a particular firm, these must be examined separately for each firm and for each industry. These factors may also be called firm-specific as these affect one firm withoutaffecting the other firms. For example, a fluctuation in price of crude oil will affect the fortune of petroleum companies but not the textile manufacturing companies. As the unsystematic risk results from random events that tend to be unique to an industry or a firm, this risk is random innature. Unsystematic risk is also called specific risk or diversifiable risk. Two of the basics statistics terms you'll want to get familiar with are variance and standard deviation. These are used to describe the difference between expected results and actual results. We need to be able to accurately measure and describe these differences to know if our betting strategy has any statistical relevance or significance.